Chapter 6: Interest Rates

Interest rates play a vital role in shaping economic activity both within a country and across international markets.
They influence the cost of borrowing, the return on savings, and the movement of capital between nations.
Changes in interest rates can affect exchange rates, the competitiveness of exports and imports, and decisions
related to cross-border investments and financing.

Understanding interest rates is essential in international business and trade, as they determine how attractive a
country is to investors, how businesses price their goods and services globally, and how currencies gain or
lose value in the global market.

What are Interest Rates?

An interest rate is the cost of borrowing money or the reward for saving money, usually expressed
as a percentage of the total amount borrowed or deposited.

When you borrow money — such as through a home loan, car loan, or personal loan — you pay
interest as a fee for using the lender's money.

On the other hand, when you deposit your money in a bank — through a savings account, term
deposit, or investment — you are essentially lending your money to the bank, and you earn interest in
return.

Why do you pay interest?

Interest is basically the cost of money. You’re paying for the ability to use money you haven’t yet accumulated,
so interest is an incentive for the bank to lend you money and a premium for the risk they take in lending to you.
Charging interest is one of the ways lenders make their profit.

What does it all mean: the big picture

We all know the interest rate is important for borrowing or saving money. So what do changing interest rates
meaning practical terms? Check out the table below for the effects of increasing or decreasing interest rates.

High interest rates Low interest rates

• Philippine Peso gets • Philippine Peso weakens
stronger
• Philippine exports are more
• Encourages saving affordable for overseas buyers

• Less disposable • Encourages spending

income
• More disposable income
• Loan repayments
increase • Loan repayments decrease
• Savings earn more
interest • Savings earn less interest

High Interest Rates

• Philippine Peso gets stronger

 → Higher interest rates attract foreign investors who want to earn better returns on Philippine bonds,
deposits, etc. They buy pesos to invest, increasing demand for the peso and making it stronger.
• Encourages saving
→ Banks offer higher interest on savings accounts and time deposits. People are more motivated to
save rather than spend because they get better returns on their money.

• Less disposable income

→ Higher interest rates make loans (housing, car, credit cards) more expensive. Monthly payments
rise, leaving households with less "extra" money to spend.
• Loan repayments increase
→ New loans have higher interest, and existing loans with variable rates (like credit cards) cost more to
repay, putting more pressure on borrowers.
• Savings earn more interest
→ Good for savers! Banks pay higher interest, so people who save money see their balances grow
faster.

Low Interest Rates

• Philippine Peso weakens

→ Lower interest rates make Philippine assets less attractive to foreign investors. They might move
money to countries with higher returns, reducing demand for pesos and weakening its value.
• Philippine exports are more affordable for overseas buyers
→ A weaker peso makes Philippine goods cheaper for foreigners. Lower interest rates support
exporters by making the peso weak and helping them stay competitive.
• Encourages spending
→ With lower loan rates and cheaper borrowing, people and businesses are more likely to buy houses,
cars, appliances, and invest in businesses, boosting overall spending.
• More disposable income
→ Loan repayments are smaller because of lower interest rates, so families and businesses have more
cash left after paying bills, giving them more disposable income.
• Loan repayments decrease
→ Lower interest rates mean that both new loans and existing variable-rate loans are cheaper to repay
every month.
• Savings earn less interest
→ Bad for savers. Banks lower the interest they pay on deposits, so saving money becomes less
rewarding — encouraging people to spend or invest instead.

How is interest calculated?

Interest is usually calculated one of two ways, depending on whether it’s simple or compound interest. Simple
interest is calculated as a percentage of your initial amount only, while compound interest is calculated (usually
every month) on the entire balance of your savings or loan, including the previous interest payments.

Simple Interest

Simple interest is a topic that most people cover in elementary school. Interest may be thought of as
rent paid on borrowed money. Simple interest is calculated only on the beginning principal.

For instance, if one were to receive 5% interest on a beginning value of $100, the first year interest
would be:

$100 × .05 –or– $5 in Interest

Continuing to receive 5% interest on the original $100 amount, over five years the growth of the original
investment would look like:
Year 1: 5% of $100 = $5 + $100 = $105
Year 2: 5% of $100 = $5 + $105 = $110
Year 3: 5% of $100 = $5 + $110 = $115
Year 4: 5% of $100 = $5 + $115 = $120
Year 5: 5% of $100 = $5 + $120 = $125

Where will I earn simple interest? If you’ve stashed your savings in a term deposit, you’ll earn simple interest.

Compound Interest

Compound interest is another matter. It's good to receive compound interest, but not so good to pay
compound interest. With compound interest, interest is calculated not only on the beginning interest,
but on any interest accumulated in the meantime.

Where will I earn compound interest? Savings accounts and bank accounts both earn compound
interest.

Where will I pay compound interest? Credit cards, home loans and car loans generally work on
compound interest. While home and car loans are calculated to be paid off by the end of a pre-
determined term, credit card interest can compound indefinitely. That’s why it’s such a good idea to pay
off your credit card balance as soon as you can.

For instance, if one were to receive 5% compound interest on a beginning value of $100, the first year
interest would be the same as simple interest on the $100, or $5. The second year, though, interest
would be calculated on the beginning amount of year 2, which would be $105. So the interest would be:
$105 × .05 – or – $5.25 in Interest

This provides a balance at the end of year two of $110.25. If this were to continue for 5 years, the
growth in the investment would look like:

Year 1: 5% of $100.00 = $5.00 + $100.00 = $105.00

Year 2: 5% of $105.00 = $5.25 + $105.00 = $110.25
Year 3: 5% of $110.25 = $5.51 + $110.25 = $115.76
Year 4: 5% of $115.76 = $5.79 + $115.76 = $121.55
Year 5: 5% of $121.55 = $6.08 + $121.55 = $127.63

Compound Interest Formula

Instead of calculating interest year-by-year, it would be simple to see the future value of an investment
using a compound interest formula. The formula for compound interest is:

For example, if one were to receive 5% compounded interest on $100 for five years, to use the formula,
simply plug in the appropriate values and calculate.
 If there was a factor that summarized the part of the compound interest formula highlighted in red in the
equation below, then to find future values all that would be necessary is to multiply that factor by the
beginning values.

Real Interest Rate vs Nominal Interest Rate

Type Definition Inflation Effect Simple Idea

Nominal The rate you see or are told Not adjusted "The interest rate before
Interest Rate (e.g., bank advertisement). for inflation. considering inflation."
"The true value of your interest
Real Interest The rate after considering Adjusted for
after inflation eats away your
Rate inflation. inflation.
money."

• Nominal Interest Rate = The surface rate. It’s what banks or lenders announce.
→ Unadjusted for inflation.
• Real Interest Rate = The actual rate showing how much you really earn or really pay after inflation reduces your
money’s value.
→ Adjusted for inflation.

Imagine:

• You put ₱100,000 in a savings account.

• The bank promises 5% nominal interest per year.
• Inflation this year is 3%.

Nominal Interest:

• After 1 year, you earn ₱5,000.

• Your total balance becomes ₱105,000.

Real Interest:

• Because prices increased by 3% (inflation), your ₱105,000 is worth less than it seems.
• Real gain = Nominal interest (5%) − Inflation (3%) = 2% real interest.

So your true increase in buying power is only 2%, not 5%.

• Nominal interest tells you how much money you get.

• Real interest tells you what that money can actually buy after inflation

Formula you can remember easily:

Real Interest Rate = Nominal Interest Rate−Inflation Rate

One more simple daily life example:

Situation Nominal Inflation Real

Bank says: "We give 7% interest" 7% If inflation is 5% this year Real interest = 2%
You borrow money at 10% loan interest 10% If inflation is 8% Real cost of borrowing = 2%

Meaning: If inflation is high, even if you earn or pay a lot nominally, the real value is much smaller!

Types of interest rates

It’s not as simple as just searching for a high or low interest rate when comparing all the products out there on
the market. There are also a couple of different types of interest rates and they each have their pros and cons.
You’ll need to carefully consider which one is going to be best for your goals, lifestyle and budget. They
include:

• Fixed interest rates

This one is pretty self-explanatory - a fixed interest rate is set at a certain percentage for the life of your
loan or account. For something like a home loan, this might make budgeting a little easier, because you’ll
pay the same amount of interest each month.

If you’re looking at a fixed interest rate, it’s important to shop around before you decide on one product -
because once you’ve locked in an interest rate, you’re usually stuck with it.

• Variable interest rates

A variable interest rate does just what the name suggests too - it varies. Depending on the market and
the LIBOR, BSP rates, your provider might raise or lower interest rates and those changes will affect the
amount of interest you pay or receive.
When you opt for a variable rate, you do leave yourself vulnerable to unfavorable market changes, but at
the same time, you have the chance to reap the benefits if the market shifts in your favor.

Factors That Affect Interest Rate

If you’ve ever gotten a credit card or taken out a personal loan, you may have wondered how the issuer or lender
decided on the amount of interest to charge you. Your credit history plays a big part, but it’s not the whole picture.
There are a variety of components, both things you can control and things you can’t, that combine to determine
your interest rate, and understanding how they work can help you secure your lowest interest rate possible. If
you have an interest in interest, read on to learn more.

Factors out of your control

Interest rates are partly based on economic factors that shift over time. You may not have any sway over these,
but once you know what to look for, you can watch for changes and take advantage of them.

• Supply and demand: When you think of interest rates as a price for borrowing money, it makes sense that
they would be affected by supply and demand. In lending, an increase in the demand for money, or a
decrease in the supply of money held by lenders, will cause interest rates to go up. For example, if a lot of
people started pulling all of their money out of their checking and savings accounts, that would decrease the
supply of money that banks have to lend to borrowers, which would likely raise interest rates at those banks.
Conversely, a decrease in the demand for money, or an increase in the supply of money, will lower interest
rates as lenders try to attract more borrowers.

• Inflation: Inflation is when the prices of goods and services rise, which decreases the purchasing power of
money. Inflation can be good for people carrying debt, since it lowers the value of each dollar you owe, but
 by the same token it’s terrible for lenders. If the money a lender receives has less value than the money it
originally lent due to inflation, it’s going to raise interest rates to account for the difference.

• Federal funds rate (Philippines is BSP Rate): The interest rate that financial institutions charge one
another for short-term loans is called the federal funds rate. It’s determined by the U.S. Federal Reserve,
which uses the federal funds rate as a lever to help balance the economy. When the economy is slow, the
Federal Reserve can lower the federal funds rate to encourage more borrowing, and when the economy is
growing too fast, which can trigger large increases in inflation, the Federal Reserve can raise the federal
funds rate to discourage borrowing. The interest rates that these big financial institutions charge one another
creates a baseline that influences the prime rate, or the interest rate that banks charge to their best customers
who have the lowest possible risk of defaulting on their loans, which in turn affects the interest rates for
everyone else. So, when the federal funds rate goes up, as it recently did, interest rates go up along with it.

Factors in your control

These are all parts of interest rates that you can choose or change, and when you get down to it, they all have
one goal: minimizing the lender’s risk. Lenders are looking for the safest loans possible, so by making yourself
a less risky borrower, you can secure better interest rates.

• Credit scores: Your credit scores impact many different parts of your life, but your ability to easily get new
credit is probably the most obvious. Since credit scores are supposed to represent your creditworthiness,
lenders look intensively at your credit scores and credit history to determine how risky you are to lend to.
High credit scores, which you can get by paying your bills on time and keeping a low credit utilization ratio,
indicate that you’re good at paying off your debts, so the risk of lending to you is low. If your credit scores
aren’t great, though, the lender views you as less likely to pay back all of your loan, so it will charge you a
higher interest rate to make up for that risk or just reject you outright. Fortunately, there are a number of ways
you can boost your credit scores, and there are even services you can hire to fix your credit for you.

• Loan amount and duration: While it may seem unfair that simply requesting a lot of money or a long
repayment term can increase your interest rate, they both make a loan more difficult to pay back. Borrowing
larger amounts of money means larger monthly loan payments, and taking out a loan with longer repayment
terms not only makes the loan more vulnerable to inflation (note that this doesn’t apply to a loan with a fixed
rate), but it also increases the chance that you’ll face some adversity in your life that may negatively impact
your ability to pay the debt. To reduce these factors, before you take out a loan, ask yourself how much
money you really need to borrow, and figure out the shortest possible amount of time in which you could
realistically pay off the debt, even if it means making a few sacrifices.

• Guarantee: A guarantee is an agreement to settle a debt in an alternate way in case the borrower defaults.
Guarantees can take several different forms, such as collateral, cosigners or a personal guarantee, and
adding a guarantee of some kind to a loan can reduce interest rates since they lower the lender’s risk. Before
you add a guarantee to a loan to reduce your interest rate, be sure you thoroughly read and understand the
agreement you’re making, as some of them can have unusual terms. Additionally, some types of loans have
preexisting policies regarding guarantees, such as auto loans, which use the vehicle you’re buying as
collateral, so you won’t always have a choice on whether or not to guarantee a loan.

The Effect of Interest Rates on Business

No matter how well your business functions, it depends on the economic environment to be healthy and
prosperous. Economic influences such as interest rates can help your company or hold it back. Once you
understand the context for running your business, you can adjust to interest rate moves to protect yourself from
negative effects and take advantage of positive ones. Interest rates can be a signal to either expand your
business or pull it back.
The Cost of Borrowing

When interest rates rise, banks charge more for business loans. This means you'll need to use more of your
earnings to pay interest on your loans, which decreases profits. You might decide not to start new projects or
expansions during periods of high interest rates, which hampers the growth of the company.
When interest remains low, businesses can borrow more readily. Low-interest loans can fund business growth
and increase profitability because businesses can earn enough off of new ventures to pay for the loan interest
and have money left over for profits.

Customers' Ability to Pay

Customers have to pay interest on their personal loans, home loans and car loans. The higher the interest, the
less money in customers' pockets. This can reduce their ability to buy products and services, so businesses may
suffer from a decrease in sales.

When interest rates remain low, customers have more cash after they pay their loan payments, and they can
spend this cash with businesses. This principle applies whether your customers are the public or other
businesses. Both have to pay interest on their loans, so the lower the interest, the more they can buy.

Boosting Business Investment

Businesses can invest their excess cash in interest-bearing accounts to make more money. During periods of
high interest rates, businesses earn more from these investments.

When rates are low, businesses may be more likely to use their cash for new equipment and plant improvements.
While this can be good for equipment sellers and construction firms, banks lose out. Banks make their money
from providing loans. When they don't get business investments to boost their assets, they can't make as much
money because they have less to loan out.

Too Low, Too Long

The interest rates banks charge are their income after expenses. When banks don't see an opportunity to make
a reasonably-high interest rate on their money, they become less likely to take risks on loans. Potentially, that
might mean you'll have trouble borrowing money for start-up and expansion expenses. Business can slow down
to a crawl because there's no way to fund innovation.

In addition, short-term loans to cover cash-flow problems can be hard to come by. This could cause businesses
to be unable to deliver goods and services to their customers because they don't have the cash to continue
operating.

The Disadvantages of a Low Interest Rate

When the economy is strong, everyone dreams of low interest rates, because this makes it less expensive to
borrow money. The Federal Reserve sets low interest-rate targets in its effort to spur the economy out of
recession. Lower rates encourage businesses and consumers to borrow and buy things. Loans put money into
circulation and raise the money supply, which supports an economic recovery -- to a point. Low interest rates
can also be a damper on the economy and your business.

Low Interest Rates and the Economy

When people can't earn attractive interest income on their money in savings accounts and certificates of deposit,
they either use their money to pay down debt or invest in goods, services or assets like houses and stocks. This
means banks lose deposits. Low interest rates also affect insurance companies that rely on a certain interest-
based return on the money they receive in premiums to support their coverage liabilities, so your insurance
premiums may rise. Low interest rates also negatively affect people who live off the interest income from their
savings, so they cut back their spending. When a large group of people, such as baby boomer retirees, reduce
their spending, overall economic activity slows. That can act to cut your sales.
How Do Negative Interest Rates Work?

Negative interest rates occur infrequently and usually only when a country's central bankers are forced to utilize
the monetary policy tool -- where the interest rates are set below zero -- during harsh economic times.

A negative interest rate means the lender is paying the individual or business to borrow money from them,
which means that borrowers get paid and savers are penalized. This strategy stimulates borrowing and lending.
A negative interest rate means that the central bank (and perhaps private banks) will charge negative interest.
Instead of receiving money on deposits, depositors must pay regularly to keep their money with the bank. This
is intended to incentivize banks to lend money more freely and businesses and individuals to invest, lend, and
spend money rather than pay a fee to keep it safe.

During deflationary periods, people and businesses hoard money instead of spending and investing. The result
is a collapse in aggregate demand, which leads to prices falling even further, a slowdown or halt in real production
and output, and an increase in unemployment. A loose or expansionary monetary policy is usually employed to
deal with such economic stagnation. However, if deflationary forces are strong enough, simply cutting the central
bank's interest rate to zero may not be sufficient to stimulate borrowing and lending.

The Theory Behind Negative Interest Rate Policy (NIRP)

Negative interest rates can be considered a last-ditch effort to boost economic growth. Basically, it's put into
place when all else (every other type of traditional policy) has proved ineffective and may have failed.
Theoretically, targeting interest rates below zero will reduce the costs to borrow for companies and households,
driving demand for loans and incentivizing investment and consumer spending. Retail banks may choose to
internalize the costs associated with negative interest rates by paying them, which will negatively impact profits,
rather than passing the costs to small depositors for fear that, otherwise, they will have to move their deposits
into cash.

Real World Examples of NIRP

An example of a negative interest rate policy would be to set the key rate at -0.2 percent, such that bank
depositors would have to pay two-tenths of a percent on their deposits instead of receiving any sort of positive
interest.
• The Swiss government ran a de facto negative interest rate regime in the early 1970s to counter its
currency appreciation due to investors fleeing inflation in other parts of the world.
• In 2009 and 2010, Sweden and, in 2012, Denmark used negative interest rates to stem hot money flows
into their economies.
• In 2014, the European Central Bank (ECB) instituted a negative interest rate that only applied to bank
deposits intended to prevent the Eurozone from falling into a deflationary spiral.
Though fears that bank customers and banks would move all their money holdings into cash (or M1) did not
materialize, there is some evidence to suggest that negative interest rates in Europe did cut down interbank
loans.

Overnight Rate (What is the Overnight Rate)

The overnight rate is generally the interest rate that large banks use to borrow and lend from one another in the
overnight market. In some countries, the overnight rate may be the rate targeted by the central bank to influence
monetary policy. In most countries, the central bank is also a participant on the overnight lending market, and
will lend or borrow money to some group of banks.

The overnight rate is the interest rate banks charge each other on loans for meeting reserve requirements. The
overnight rate is frequently confused with the discount rate, which is the interest rate Central banks charges on
loans but they are different rates.

The overnight rate is the interest rate banks charge each other on loans for meeting reserve requirements. The
overnight rate is frequently confused with the discount rate, which is the interest rate the Federal Reserve
charges on loans from the Federal Reserve Bank, but they are different rates.
How it works (Example):

Banks receive income from loans and it is best for them to loan out as much as possible. But if a "run on the
bank" occurs and a large number of depositors suddenly try to withdraw their money, the bank risks failure
because it does not have the actual cash to pay all depositors at once. To prevent the chaos that would naturally
occur in this situation, the Federal Reserve maintains what is called a fractional reserve banking system. The
fractional reserve banking system requires banks to keep a certain percentage of their deposits liquid to
accommodate a normal number of withdrawals from depositors at given time.

When a bank cannot meet reserve requirements, it can get a Federal Funds loan. These loans are unsecured
and are for very short periods (typically overnight).

An increase in the overnight rate discourages banks from borrowing to meet reserve requirements. This, in turn,
encourages them to retain more reserves and lend out less money. A reduction in the overnight rate has the
opposite effect: it encourages banks to borrow to meet reserve requirements making more money available for
lending. Because the increase in the supply of funds available for lending puts downward pressure on interest
rates, changes in the overnight rate can have economy altering effects.
Name: _____________________________ Day / Time: ______________ Score: _________

1. What happens if interest rates stay low? Do lower interest rates stimulate the
economy?

2. Is negative interest rate good or bad? Discuss you answer?

3. Why are interest rates important to the economy? Explain